Gold’s old ceiling or a new floor?

Joe Foster,

15 June 2018

Gold declines as US dollar strengthened in May

Gold remained resilient in May, as the US dollar strengthened
considerably. The US Dollar, as measured by the DXY Index gained 2.4% and
closed the month at its highs for the year, driven by new fears of an Italian
debt default and EU breakup. In Italy, populist parties from the left and right
have formed a coalition government that may drive the country further into debt
and to promote initiatives that would enable Italy to exit the euro. Italian
President Sergio Mattarella blocked the coalition, which effectively suspended
their plans. We expect to see the coalition make further attempts to gain power,
which should keep the markets on edge for the foreseeable future.

As the DXY gained, the gold price fell to its low for the year
of US$1,282 per ounce on 21 May.Gold subsequently advanced into month-end as
the Italian situation rose to a boil, ending at US$1,298.52 per ounce for a
monthly decline of US$16.83 (1.3%).

Gold responds to systemic risks, not headlines

It seems that every time new, scary headlines emerge, press
articles declare that gold no longer serves as a safe haven. The Italian political
crisis is the latest case in point. The evolving situation in Italy is
supportive of gold, as shown by its resilience against a strong move in the US
dollar. However, anyone expecting a big move from gold fails to understand the
fundamentals of the gold market. Gold responds to genuine global systemic
risks. These are risks that can have a negative financial impact on just about
everyone personally and/or professionally, i.e., risks that bring excessive
inflation or deflation, currency, debt, banking crises, or geopolitical events
that impact trade and commerce. Localised risks that are the subject of most
headlines do not elicit a strong response from gold.

Stock, bond, and currency markets reacted violently to the
Italian news. However, the gold market remained calm, which tells us that, so
far, this is not the systemic event that the headlines are implying. The
chances of an EU breakup are still very small. The euro has survived Greece and
Brexit. Gold price action indicates the EU will survive Italy as well. If the
situation reaches global systemic proportions, we are sure there will be a
strong response from the gold market. Until then, investors should be wary of
the implications of the seemingly endless stream of scary headlines.

Gold can also have a different response locally that many
American reporters ignore. In euro terms, gold gained €25.62 (2.4%) in May,
making a new yearly high. Italians holding gold have a safe haven hedge.

Many indicators continue to tell us the economy is very late in
the cycle. The current economic expansion is now the second longest on record,
surpassed only by the tech boom of the 1990s. Convertible bond issuance by tech
companies is on pace to challenge the levels last seen in 2000. The stock
market is struggling to return to its highs, even though S&P 500 companies
spent US$158 billion buying back stock in the first quarter, a record pace
according to a report from the S&P Dow Jones Indices. Delinquency rates for
subprime auto loans have surpassed the levels of the global financial crisis.
Financial regulation has come full cycle, as Congress passed a deregulation
bill in May and the Fed advanced a proposal to ease the Volcker rule, both
aimed at reducing crisis-era regulations. The Fed is tightening, but rates are
still far below normal at this stage of the cycle. Accommodative monetary
policies continue to promote asset price inflation. In May, the Rockefeller
Collection auction surpassed all expectations, raising US$832 million, nearly
doubling the previous record for a collection, which was set in 2009.

Economic down-cycles are normally a healthy and somewhat painful
way of cleansing the economy of bad debts, dead beat companies, and crooks. The
extraordinary risk facing the financial system is that central banks have
little to no room to stimulate when the current cycle comes to an end. There is
no capacity for fiscal stimulus either and sovereign debt service could become
very problematic. Fiscally, the developed world is looking more like Italy all
the time.

The US$1,365 question

The second half of 2018 should be very interesting for the gold market. The chart shows the gold price has formed a wedge or pennant pattern that has been in place for several years. The positive aspect of this pattern is the trend of higher lows. Fundamentally, gold has been resilient, gaining strength from escalating geopolitical risks and uncertainties. The negative aspect is the ceiling that has formed around $1,365. There has not been a strong catalyst to take gold to a new higher trend line. Investors have been frustrated by this range bound price action, while speculators have been put off by the decreasing volatility. The apex of the wedge occurs in early 2019; therefore, we believe it is inevitable that gold will begin to establish a new trading pattern by year end.

Gold Price Chart, 2013 – 2018

Source: Bloomberg. Data as of May 31, 2018. Past performance is not indicative of future results.

Without a second half catalyst, gold will probably drift sideways, falling below the lower trend line and further eroding confidence in the metal. However, in the second half of the year, we could see catalysts that may boost gold to a higher range that draws new attention from investors. To start, the geopolitical risks that have been supportive of gold are likely to continue – tensions in the Middle East and North Korea, and uncertainty surrounding Trump administration policies. With the economy firing on all cylinders and lofty commodities prices, an inflation surprise is possible. Mid-term elections in the US may result in destabilizing shifts in power if the Democrats prevail. Leadership changes in Italy are set to bring added risks to European banks, sovereigns, and the euro. Last but not least, signs that the post-crisis expansion is nearing its end may emerge.

Gold tested the low end of its trading range in May. As gold has shown price weakness ahead of Fed rate increases, we expect gold to continue to drift around the bottom of the range until the expected rate increase on 12 June. Futures positioning and flows into gold bullion exchange traded products suggest gold is poised for another post-Fed meeting rally.

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